Currency markets can behave much like a cat – sit around for hours, days and weeks seemingly uninterested and content with the status quo.
This has been the case for the Australian dollar for the better part of the last year, hovering within a few cents of 104 US cents with as much direction as the Himalayan variety of feline.
So one can understand how complacency (let’s not call it laziness) can creep into market participants. People have become accustomed to an Aussie dollar entrenched above parity with seemingly no end in sight.
For many importers this meant less urgency to hedge against the possibility of a drop in the value of the Australian dollar. It has been common for importers in this environment to transact at a spot exchange rate, taking the day’s rate, instead of paying unnecessary costs to insure against the chance of such an outcome (via a forward exchange contract or option).
Fear and greed: the pain of a loss
Believing the good times will continue to roll, being complacent or having a lack of urgency is, however, a dangerous mindset to be in. It’s when drivers take their eyes off the road that accidents occur, and the recent drop below parity in the Aussie dollar has certainly caught many businesses unprepared.
When faced with this scenario people’s decision-making is usually driven by either fear or greed. So they either take out hedging immediately to protect against a further decline (fear-driven) or they wait for the price to recover (greed-driven).
There has been plenty of research done over the years on the psychology behind these types of feelings. One of the most famous is the work of Amos Tversky and Daniel Kahneman (The Framing of Decisions and the Psychology of Choice, 1981) which looked at the impact cognitive bias has on decision-making.
In part they concluded that the way people react to a particular choice depends on how the choices are presented to them. Their studies in this field led them to what is termed ‘prospect theory’, which shows a loss is more significant than the equivalent gain.
Fear driving FX hedging decisions
At OzForex we have certainly seen the power that the fear of loss can exert. As the Australian dollar dropped quickly below parity, many analysts are now expecting further declines – some have a 12-month target on AUD/USD below 90 cents.
As a consequence there has been a sharp increase in demand for hedging products from importers concerned about the impact a lower currency may have on the profitability of their business.
Fear-based decisions are not necessarily wrong and it is a basic human instinct to seek certainty or safety when feeling vulnerable. This may in fact be the best course of action.
Inaction can be a sign of greed
On the flipside, while the power of fear tends to lead to action, greed can actually trigger inaction or indecision. It is common for some to prefer to play the waiting game, believing that either the “market is wrong” or that there will be a major correction which will give them the opportunity to achieve a better rate at some point in the future.
While this is possible (the future is unknown) it can be an accident waiting to happen, or like the surfer waiting for the perfect wave that may never come. The importer waiting for a return to those days where the Aussie dollar traded comfortably around 104 U.S cents against the greenback could be waiting a very long time.
Control emotion – have a plan
For businesses caught at the crossroads, unsure of whether there is more downside in the Australian dollar, it is important to understand the reasoning behind their decision, or indecision for that matter.
Is it greed or fear that dictates your current strategy? We recommend taking emotion out of the equation altogether and having a written, formalised plan – an FX policy – to guide the decision-making process instead.
Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.